Banks, Rating Firms Square Off Over Mortgage Bonds

U.S. banks struggling to restart their issuance of mortgage bonds central to the financial crisis are finding credit-rating firms as their latest hurdle.

One J.P. Morgan Chase & Co. executive made that point clear on Thursday during a conference at the investment bank, noting “somewhat heated” discussions with one rating firm about the bank’s effort to curb the risk of future litigation over a loan’s underwriting.

As the market for private residential mortgage-backed securities shows signs of life, J.P. Morgan and others want a new practice of including time and other restrictions in so-called representations and warranties that assure investors of the quality of loans in mortgage bonds. Two recent bonds issued by Credit Suisse included some limits to the periods where investors can demand lenders or the investment bank repurchase faulty loans.

Banks have already paid billions of dollars over alleged breaches on “reps and warrants” on subprime and other non-guaranteed loans issued at the peak of the last real-estate bubble, and the new restrictions are an effort to avoid legal battles if the real-estate market collapses again.

The disagreement could stall the recovery of the private mortgage-bond market, which finances loans that don’t meet the size or credit requirements of government programs of Fannie MaeFreddie Mac and the Federal Housing Administration.

Congress and the Obama administration are eager for the private market to originate more loans, helping to expand credit availability, but the lenders have struggled with greater regulation and also to compete against the federal programs that still offer the lowest cost of funding on the vast majority of mortgages.

By creating mortgage bonds that partially limit their liabilities, lenders and investment banks could create greater certainty on future costs on their private-issue bonds, giving them more incentive to lend to a broader array of borrowers.

Banks are expected to ramp up participation in the market that topped out at about $5 billion last year, a pittance compared with the more than $1 trillion issued in 2006. But getting rating firms to agree with efforts to craft reps and warrants that offer them some legal cover has been tough, said Liam Sargent, J.P. Morgan’s global head of asset-backed and non-agency mortgage trading and syndication, and head of capital markets for Chase Home Finance.

J.P. Morgan recently showed a rating firm one proposal in which there wouldn’t be a presumption of a breach simply because a borrower defaults, Mr. Sargent said at a J.P. Morgan conference on Thursday, which was closed to the media but available by webcast. He didn’t refer to any specific bond deal.

He said that the rating firm, which he didn’t identify, wants a procedure by which investors would automatically search for a breach if there is a default. This will increase chances of litigation, he said. On Monday, a J.P. Morgan spokeswoman declined to comment further.

Moody's Investors Service and Fitch Ratings last month cited concern over mortgage bond rep and warrant proposals that would allow lenders or issuers to escape some of their legal liabilities.

If bonds could expose investors to defective loans, bond issuers may need to beef up other protections for senior bondholders to get a top rating, Fitch said in a Feb. 20 report. Fitch declined to comment on Mr. Sargent’s comments.

Moody’s said in a later report that weak rep and warrant structures can prevent top ratings. A Moody’s spokesman on Friday said the firm has had discussions with potential RMBS issuers and shared the opinions of its report.

J.P. Morgan is hoping new bond documents define a “framework” by which an independent party is assigned to review a breach of reps and warrants, and which clearly defines a breach and requires binding arbitration, Mr. Sargent said Thursday. Without that, RMBS issuance by banks that are also adapting to new Securities and Exchange Commission disclosure rules will be difficult, he said.

“Every time we talk to our lawyers they get more and more concerned that without a framework we’re going to have massive litigation risk down the road,” Mr. Sargent said. “This, to me, is the biggest thing we can work on” to help bring private capital back to the mortgage market, he said.